1031 Exchange: How Real Estate Investors Avoid Capital Gains Tax

If someone owns or inherits investment property in a real estate market that has recently exploded in value, she may consider a 1031 Exchange in order to avoid paying capital gains tax which is a tax levied on what the seller earns from the sale of the property.

Property investors who have properties in places like San Francisco, Los Angeles, Orange County and New York City are sitting really pretty due to the incredibly high appreciation values their investment properties have gone through over the last 10-20 years.

But maybe those properties are not earning enough rental income and they would like to swap them out for other properties that can double or triple the rental income without having to pay a capital gains tax on the sale of the original investment. They can do so under the tax loophole called the 1031 Exchange.

What Properties Qualify Under A 1031 Exchange?

Only real estate investment properties qualify under a 1031 Exchange. A person cannot just sell their residence for another residence or sell their residence for investment property. The original property being sold has to already be an investment property and the money earned from the sale to go towards another investment property or properties. The properties must also be in the United States.

So Susie, who owns an investment house in Santa Monica she has been renting it out for the past 15 years, can now sell that house and buy 10 investment properties in Arizona or New Mexico.

Does The Value Have To Be The Same?

The value of the “swap” has to be the same value or higher on the purchase. It also has to match up if there is a loan on the original property being sold.

For instance, if Susie’s investment house in Santa Monica sells for $2M and has a $200,000 mortgage on it, her next purchase of investment property or properties have to add up to at least $1.5M and there has to be a $200,000 mortgage in there somewhere.

Does The “Swap” Have To Happen At The Same Time?

The swap does not have to be made at the same time. I mean ideally it could happen that way, but in a real estate market that changes from city to city and state to state, that’s not a likely scenario these days. But there is a time limit on certain things.

After selling the original investment property, the investor must then identify up to 3 like-kind properties within 45 days. “Like-kind” means other real estate investment properties.

Then the investor has 180 days (6 months) to close on all the properties from the date of the original investment property’s sale. But if the investor asks for an extension for her tax filing, it would then be 180 days from the day the extension is approved.

So What Happens To The Money After The Sale of the Original Property?

When the original property is sold, a qualified intermediary, who is not the investor, handles the transfers and does the proper paperwork necessary in order for a 1031 exchange to happen.

Do I Need A Realtor?

Most investors who have done a 1031 Exchange have praised their great realtor on the ease and of it all. Realtors know their real estate markets very well and would have a very good idea of where the money can be reinvested in order to grow wealth and ensure a higher return.

Ramsey Judah is a real estate broker with The Judah Group and can be reached at ramsey@TheJudahGroup.com and @RamseyJudah on Twitter and Instagram.